Along with wages and healthcare, the ability to participate in a retirement plan, usually a 401(k), is a key component of a company’s employee compensation package. 410(k) plans offer employees the ability to defer the taxation of contributions until the money disbursed from the 401(k). The employee benefits from a reduction in taxable income in the year of contribution, as well as the compound growth over time of the amount that would have been paid to Uncle Sam. Furthermore, about half of employers offering 401(k) plans match employee contributions, with the average being about 3.5% of salary. After paying down expensive debt and building a safety fund, maximizing contributions to a 401k plan should be high on any savers “to do” list.
401(k) plans are a great retirement savings vehicle for employees of large businesses, but what do you do if you are self-employed or an independent contractor? Fortunately, there are low cost, easy to administer options for the self-employed as well. Each plan has unique features, which can be positive or negative based upon the individual’s circumstances. Below we will explore the benefits and limitations of two popular options, Self Employed Pension IRAs (SEP IRA) and Solo 401(k)s.
Self Employed Pension IRA (SEP IRA)
SEP IRAs are a great option for self-employed or small business owners that have no or only a few employees. With high contribution limits and low administrative burden, they are simple to implement and effective savings vehicles. SEPs IRAs allow for much higher contributions than a traditional IRA and the deductibility of contributions does not phase out at higher income levels.
Benefits
- Contributions can be made up to the lessor of $57,000 (in 2020) or 25% of compensation or net self-employment earnings, with a $285,000 limit on compensation for the purposes of the calculation. (Note that net self-employment earnings are your net profit less 50% of self-employment taxes, which are 15.3% on the first $137,000 in 2020)
- Contributions made up to the limit are deductible from self-employment earnings for tax purposes.
- Contributions can be made up until the tax filing deadline.
- SEP IRAs are easy to open and have no IRS reporting requirement.
Limitations
- The employer must make equal contributions, measured as a percentage of income, to each eligible employee.
- Generally, an employee is eligible if they:
- Are older than 21 years-of-age
- Have worked for the company for 3 of the previous 5 years
- Have received $600 (as of 2020) or more in compensation in the current year
- Employees cannot make contributions to their SEP IRA accounts.
- There are no catch-up contributions for older savers.
- Required minimum distributions (RMDs) are required starting in the year that the owner turns 72 years-of-age.
- There is a 10% penalty on withdrawals before the age of 59 ½, with some exceptions.
Solo 401(k)
Solo 401(k)s are modeled after a typical 401(k) plan. The use of Solo 401(k)s is limited to businesses that have no full-time employees, other than the owner and their spouse. Solo 401(k)s may offer a Roth option, for savers that expect to be in a higher tax bracket in the future. The administrative burden is slightly higher than a SEP IRA, but they may allow for substantially higher contributions, under the right circumstances.
Benefits
- The total contribution limit is $57,000 in 2020, or $63,500 for those 50 years-of-age or older. Contributions are made at both the employee and employer level, with sub-limits for each category
- As the employee, you can contribute up to $19,500 in 2020, capped at 100% of compensation. For those age 50 or older, the limit is $6,500 higher.
- As the employer, you can make an additional contribution up to 25% of your compensation or net self-employment income. Net self-employment income is your net profit less 50% of your self-employment taxes and less any personal employee contributions made. Compensation is limited to $285,000 for this calculation in 2020.
- Contributions made up to the above limit above are deductible from self-employment earnings for tax purposes.
- Solo 401(k)s may offer a Roth option which does not provide a tax deduction upfront, but distributions are made tax-free in retirement.
- If your spouse earns income from the business, they can make elective deferrals as an employee and are eligible for profit-sharing contributions from the employer.
- The employee must elect to make the deferral by December 31st, but the actual contribution, along with the employer’s profit-sharing contribution, can be made up until the tax filing deadline.
- Loans may be taken out against the balance in some cases
Limitations
- The business may not have any full-time employees other than the owner and their spouse. Part time employees working less than 1000 hours a year are allowed.
- When the plan assets exceed $250,000, the IRS requires that the plan files a Form 5500-EZ every year.
- RMDs are required starting in the year that the owner turns 72 years-of-age. Solo Roth 401(k)s can be rolled into a Roth IRA to avoid RMDs.
- There is a 10% penalty on withdrawals before the age of 59 ½, with some exceptions.
Comparing SEP IRAs and Solo 401(k)s
The optimal retirement savings vehicle will vary based upon the unique situation of each individual. Below we highlight some of the meaningful differences that could push an individual towards a SEP IRA or Solo 401(k).
- Solo 401(k)s may be attractive to individuals that expect to have high- or low-income years. For high earners, the ability to add your spouse as an employee could greatly increase their annual contribution limits. Low earners, can make employee contributions up to 100% of compensation, even if the employer profit sharing contributions are limited.
- SEP IRAs are very easy to set up and have virtually no administrative work. Furthermore, the ability to establish and fund the account up until the tax filing deadline provides a high degree of flexibility.
- Individuals who contribute to a 401(k) at another employer and earn self-employment income from a “side hustle” will see the employee contribution limit of the Solo 401(k) reduced by any contributions made to the other employer’s 401(k). That individual could still contribute the full 25% of net self-employment income to a SEP IRA, regardless of the 401(k) contribution.
- Businesses that utilize seasonal staff with high turnover may be prohibited from contributing to a Solo 401(k), but could still utilize a SEP IRA.
In summary SEP IRAs and Solo 401(k)s offer self-employed individuals two great options for retirement saving. Their unique circumstances will dictate which of the two best suit their objective. If you would like to learn more about SEP IRAs, Solo 401(k)s or other retirement plans, please reach out to us and set up an introductory conversation.